Jeffrey Sica serves as the president and chief investment officer of Circle Squared Alternative Investments, as well as Sica Wealth Management which are both based in his home state of New Jersey. Throughout his career Jeff has advised affluent high net worth clients and businesses with financial planning, asset management, and private equity services. As he found more and more clients were looking to diversify their portfolios and reduce volatility, he created Circle Squared to create special unique opportunities in the alternative investment space. With more than 20 years in the financial industry, Jeff has also held positions at AG Edwards and Wachovia/Wells Fargo Advisors. He is also a regular source for the financial news media.

No Shelter ~ What's Behind The Destruction of The Income Investor

I started my career as a wealth manager at a conservative municipal bond firm in the midst of the raging bull market of the 1990’s. My typical client was very conservative with a primary goal of stability of principal and a secondary goal of income, usually tax free income. These investors were only interested in treasury bonds, municipal bonds and sometimes if they wanted to get crazy and take what they considered a risk, high grade corporate bonds. Many of my income oriented clients were very suspect of the gains that people were making in the stock market, with returns averaging over 20% from 1995-1999 in the S&P 500. However there were those who began to consider the 5-6% they could get tax free in municipal bonds as being subpar compared to what they could get in the raging stock market. It was at that moment I began to see the first partial migration out of the bond market into the stock market as a way to chase astronomical returns. This migration was my first example of how powerful the herd mentality is and why the fear of “missing out” often surpasses the fear of losing principal when it comes to chasing market returns. The result of income investors chasing stock market returns was participation in one of the biggest stock market crashes ever as the stock market declined 50% in the next three years. The income investors who didn’t follow the herd mentality survived the crash brilliantly. Unfortunately, those who migrated to the stock market were severely impacted by the crash salvaged what money they had left, and began investing in bonds again, that is, until now.

Herd

There is a quote by C.S Lewis that says “experience is the most brutal of teachers, but you learn, my God do you learn”. I had left the conservative bond firm a few years before the crash to pursue a more “diverse” company that accommodated both conservative income investors and growth equity investors. In many instances I willingly followed the herd mentality which favored the stock market and in some ways ignored the bond market. As a rookie adviser, I had an extremely high percentage of client assets invested in stock and often recommended income investors to diversify into and even over allocate the stock market. After all if the majority of investors believed in something, I thought it must be true. The market crash was a brutal teacher for me and my God did I learn. Most importantly, I learned to trust my instincts, and to never fully trust the herd mentality again. Unfortunately some brutal lessons have to be taught repeatedly to finally learn from them. After 20 years, I fully accept that the herd mentality couldn’t be trusted then and it certainly can’t be trusted now.

Desperate

It’s apparent that no matter how well intentioned people may be, their actions done out of desperation usually turn out to be disastrous. The sub-prime crisis, massive stock market crash, and recession of 2008 thrust the world economy into one of the worst dilemma’s this nation has ever seen. The government and Central Bank needed to take decisive action to prevent the world economy from falling into a multi-decade abyss. The Central bank took action, created a deluge of liquidity by printing massive amounts of money and bought treasury bonds as a strategy to keep borrowing cost low. The result was treasury bond prices were inflated and yields declined, creating the lowest treasury yields in history. The peripheral bond market also experienced significant inflation as investors desperate for income, bought anything they could find with any degree of yield. The income investor, since 2008, became desperate to find a way to fill the void that low yielding bonds created in their investment income. It is in this desperation that income investors have turned to other investments to fill that void. The result is the second migration of income investors to the equity market in two decades. There was an exodus of income investors who were forced out of the bond market by inflated bond prices and low yields, and into the stock market mostly dividend paying stocks. The reasoning behind this flight is, if you can’t get 5% income from a bond portfolio without excessive risk of interest rates rising you might as well invest in a stock paying a 5% dividend. The first migration of income investors out of the bond market represented investors willingly investing in the stock market to achieve stock market returns. The current migration represents income investors migrating into the stock market out of desperation, many have essentially been forced into it.

Identity Crisis

The most important decision an investor will make is deciding what kind of investor they are and what types of risks and volatility are they willing to accept to achieve their investment goals. A strategy which involves investing in dividend stocks could be a successful strategy for those willing to accept stock market risk. An income investor with minimal risk tolerance who has followed the herd mentality and invested in the stock market out of desperation as a way to achieve yield will be quick to sell when the market begins to decline. The core identity of most income investors is they have a general distrust of the stock market, this distrust will reveal itself as an avalanche of selling when the market begins to decline. The central bank has successfully inflated the stock market, setting off this avalanche. The issue is not that the stock market is inflated, it’s who are the investors that inflated it and how will they react when the bubble begins to deflate. A very significant percentage of investors in dividend paying stock are really income bond investors suffering from an identity crisis, they will sell when they finally accept who they really are.

Shelter

The market which declined 8% recently included a significant percentage of dividend paying stocks. This is a foreshadow of what will happen when income investors learn that dividend paying stocks are no shelter when it comes to market declines. The only true shelter an income investor will experience will be the result of patience and diligence in finding opportunities which successfully fill the void. Now, twenty years later as president of my own wealth management firm, I think back to my first days as an adviser and all the lessons I have learned along the way. I had nothing but a screen with stock quotes and an occasional news story. Now I sit staring at 7 computer screens feeling as if I’m on constant information overload sorting through financial data from all over the world all for the sake of protecting and prospering my clients in uncertain times. Although I’ve worked with clients with varying investment goals, the one thing my clients always wanted more than anything is what I work most diligently to find in uncertain times….shelter.

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While it may not help current income-focused investors, a return to Total Return Investing across a lifetime would seem to be the best antidote to the current environment of income chasing. Both that and reducing spending, modifying living style, seems to be the only solution for those inclined to climb up the risk ladder.